CME seen needing CBOE as slowing profit growth spurs speculation

Low interest rates seen eating into volumes

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July 18 (Bloomberg) -- For CME Group Inc. to improve the exchange industry’s worst profit outlook, the owner of the Chicago Mercantile Exchange needs only to look across the street to CBOE Holdings Inc., home of the biggest U.S. options market.

CME’s net income will decline 19 percent in the next three years, according to analysts’ estimates compiled by Bloomberg. CBOE, a $2.47 billion company forecast to boost profit 26 percent in the same period, has rallied more than every developed-market peer of similar size during the past two months and reached the richest price-earnings ratio versus the industry since September, the data show. That may be a sign of takeover speculation, according to Caldwell Securities Ltd.

Macquarie Group Ltd. and Sandler O’Neill & Partners LP say CME would be the most logical suitor because it owns a quarter of S&P Dow Jones Indices, which has given CBOE exclusive rights to one of its biggest moneymakers: trading Standard & Poor’s 500 Index options. Expanding into equity options would provide new revenue for the largest U.S. derivatives exchange owner in a market that set a ninth straight annual volume record in 2011.

CBOE’s “stock is telling you something is happening,” Thomas Caldwell, who oversees about $1 billion as chairman and chief executive officer of Toronto-based Caldwell Securities and owns CBOE shares, said in a phone interview. “It’s one of the few bright spots in the exchange space worldwide, so that in itself should command a premium,” Caldwell said. “CME’s position would be unassailable” with a purchase of CBOE.

Corn, Crude

Carol Kennedy, a spokeswoman for Chicago-based CBOE, declined to comment on the company’s prospects for being bought. Michael Shore of CME also declined to comment.

Founded in the 19th century, CME’s business spans agricultural, energy, metal and financial futures tracking products such as corn, crude oil, gold and interest rates. The Chicago-based company that’s valued at $17.5 billion has expanded in the past decade with deals, buying the Chicago Board of Trade and New York Mercantile Exchange owner Nymex Holdings Inc. The purchases cemented CME’s dominance in futures, giving it a U.S. market share of about 98 percent.

The Chicago Board Options Exchange, started in 1973 as the first U.S. equity derivatives market, became the last major American bourse to convert to shareholder ownership with its 2010 initial public offering. Former members of the Chicago Board of Trade, now owned by CME, helped found the options market. Their fight over ownership rights delayed CBOE’s IPO.

Fed’s Decision

Net income at CME will fall to $1.46 billion in 2014 from $1.81 billion last year, according to analysts’ estimates compiled by Bloomberg. The Federal Reserve’s decision to hold borrowing costs near record lows since December 2008 has helped slow CME’s volume for interest-rate futures, its most-traded product. In January, the central bank said it plans to keep holding down rates through at least late 2014, meaning investors have less need to hedge the risk that rates will rise.

At the same time, more than 4.6 billion contracts changed hands last year, continuing a streak of annual records that began in 2003, data compiled by OCC show. Transactions are now spread out across 10 venues, including those run by NYSE Euronext, Nasdaq OMX Group Inc. and Deutsche Boerse AG. CBOE captured the most total market share in June with 30 percent of U.S. trading on its two bourses.

S&P Dow Jones Indices, owned 24.4 percent by CME, 73 percent by McGraw-Hill Cos. and the rest by News Corp., has granted exclusive licenses to CME for futures based on the S&P 500 and to CBOE for options on the benchmark measure of U.S. stocks. That shared connection would probably make it easier for CME to buy CBOE, said Richard Repetto, an analyst at Sandler O’Neill in New York. CBOE’s license expires in 2018.

Valuation Premium

Repetto estimates CBOE gets at least 30 percent of net income from S&P 500 options. Shares of the exchange have rallied 15 percent since their 2012 low on May 17, beating every developed-market peer valued at $2 billion or more, data compiled by Bloomberg show. The gain drove its price-earnings ratio to 17.4, 19 percent more than the valuation for the Bloomberg World Exchanges Index of companies with an average market capitalization of about $4.2 billion. The ratio was 20 percent higher on June 18, the most since September.

“CBOE is attractive as an acquisition to large exchanges,” said Ed Ditmire, a New York-based analyst at Macquarie. “After all, it’s somewhat bite-sized relative to other public exchanges,” he said. With S&P Dow Jones Indices, “CME would have the best chance of finding comfort with the continuation of that contract, in addition to the obvious Chicago advantage that they’d have,” Ditmire added.

Today, CBOE shares added 0.7 percent to $28.40, the highest level since March 30.

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